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RETAIL SLOWDOWN HITS NET LEASING

By Donna Mitchell

A vital part of retail property finance for more than 50 years, the single-tenant net leasing business has recently come under pressure from regulatory and market forces.

A pullback in retailers’ expansion plans along with regulatory changes from the Financial Accounting Standards Board have undermined deal volume expectations for 2002. Surprisingly, record low interest rates haven’t helped either.

A net lease is an arrangement in which a commercial property tenant pays, in addition to rent, various levels of taxes, insurance and maintenance on a property. This reduces the burden on landlords and tenants alike. The landlord can simply collect the rent, while the tenant doesn’t have to lay out a lot of cash to actually purchase the property. There are three levels of net leasing: Net leases include rent and other property fees; net-net leases include rent and insurance; and net-net-net, or “triple-net,” leases include rent, insurance and maintenance costs.

In the retail sector, net leasing is most commonly used to finance freestanding locations. (CVS, Staples and Walgreens are among the many that have used it to help finance their expansion plans.) Retail pushed net leasing to new heights last year, with retailers, optimistic about retail sales growth, mapping out aggressive expansion plans. It is not easy to tally the retail portion of the net lease market, because only deals of $1 million to $5 million and above are counted. But Real Capital Analytics, a New York City-based commercial real estate research and consulting firm, estimated that in 2001 the market generated slightly more than $1 billion in net lease transactions on single-tenant retail deals above $5 million. (The company’s data goes back only to July 2000, making comparisons with previous years difficult.) Also, more companies began offering net leasing, lured by hot prospects for new business.

But business hasn’t been as brisk this year, despite fitful stock markets that have pushed investors to more-stable real estate investments, and despite record-low interest rates. So far this year, Real Capital has tracked about $400 million of single-tenant retail deals, said Robert M. White, the company’s president. Among other things, large national retailers have curtailed expansion plans because of economic uncertainty.

“There are not as many new stores available,” said Gary Ralston, president and CEO of Orlando, Fla.-based Commercial Net Lease Realty. The REIT specializes in developing, arranging financing and buying single-tenant properties for retailers. With 241 properties in 36 states, Commercial Net Lease controls more than 6 million square feet of gross leaseable area. The acquisitions group, which arranges sale lease-back financing for retailers, accounts for 65 percent of its business, while the build-to-suit group accounts for the rest. The beauty of net leases, Ralston notes, is that net lease retail is built in response to demand, so that once a building is ready, the tenant is already lined up. “[Retailers] wanted to see how store sales would grow before being committed to a store expansion.”

Low interest rates pose another difficulty for deal growth. Instead of financing new properties now that the 10-year Treasury is at 3.75 percent, retailers are refinancing their existing properties to save on debt servicing. So-called older deals, meaning single-tenant properties occupied by good credits carrying no debt and with 15 years left on the lease, are sustaining the market now, said James Koury, a senior vice president at Spaulding & Slye Colliers, Boston, a real estate services company.

Also keeping the industry in a holding pattern was the wait for regulators to come up with rules in response to corporate accounting scandals. At press time the Financial Accounting Standards Board was expected to publish stricter guidelines governing special purpose entities, or SPEs, which include net leases. While the regulations are designed to limit off-balance-sheet partnerships of the kind that brought down Enron, they are also affecting less-dubious forms of SPEs, industry insiders say.

“Part of what drives the net lease marketplace is capital and the ability to leverage transactions,” said Ethan Nessen, principal of CRIC Capital, Boston. A joint venture of Corporate Realty Investment Co. (CRIC) and Prudential Real Estate Investors, CRIC Capital is a major provider of net lease financing. The scandals involving Enron and WorldCom have bred a strong conservative mind-set in the marketplace and put a damper on the drive to put more debt on the market for investment.

“The tremendous irony to [the accounting scandals] is that it has been the ‘pristine,’ high-investment-grade companies that have had all the problems,” said Nessen. “But the [companies] lower down on the food chain have been punished.”

Regulatory threats notwithstanding, net leasing is expected to continue to thrive. It has certainly been around for a while. The product first came onto the real estate financing scene in the 1950s, introducing the idea that companies could sell or develop property without putting up their own money, explained Nessen. Early net leases offered property lessees tantalizing features, such as diminishing rents over time, low fixed renewals and tax advantages.

In the 1970s individuals used net leasing as a form of estate planning, said Steven Sanders, senior vice president of acquisitions for Inland Retail Real Estate Trust, Oakbrook, Ill. (The company owns about 60 community centers and leases some of its properties back to retail tenants.) It was a nice way to pass on to heirs an asset that appreciates in value. Wal-Mart, Kmart and other retailers caught on to “sale leasebacks” as they expanded nationally.

Over the decades, retail landlords and tenants understood that net leases could be used as credit-based debt instruments, and started to take advantage of that, said Nessen. Net leases evolved to encompass such products as sale leasebacks and credit-tenant leases. In a sale leaseback, a property owner sells the real estate to an institutional investor or other buyer, then leases the property back. A credit-tenant lease is a set rental rate based on the tenant’s credit rating, which must be at least investment-grade, and its level of long-term debt.

“Sale leaseback was a convenient way for national stores to expand without dipping into the corporate treasury,” Sanders said.

For all the recent economic and regulatory problems, retailers are not expected to abandon net leasing, and market players remain upbeat about the years to come.

“I think once those regulatory changes are finalized or at least known, then we will see significant volume pick up,” said Paul McDowell, CEO of Capital Lease Funding. Based in New York City, Capital Lease Funding specializes in net leasing as a direct lender and has financed more than $2.5 billion in credit-tenant lease loans on 400 properties.

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